Money management – a trader’s best friend
This is not a trading system, but a money management system and we will show you how a little thing can help you achieve higher rewards with the same risk.
Let’s say we normally trade 1 lot with a Stop Loss of 30 pips and a Take Profit of 30 pips, thus a 1:1 Risk to Reward ratio. One pip movement means $10 so if our Stop Loss is hit, we lose 300 US Dollars and if our Take Profit is hit, we win 300 US Dollars. Now this is the modification: instead of using 1 lot, we will use 0.50 lots. Let’s assume we place a long trade at 1.2000 with Take Profit at 1.2030 and Stop Loss at 1.1970. If our trade goes straight to Take Profit, we win 150 dollars.
We lowered the Risk and also we lowered the Reward, but the ratio stays the same, 1:1 If the trade goes 10 pips against us, we open another long trade with 0.50 lots (Stop Loss is the same as our first trade, 1.1970). Now if the trade goes our way and hits the Take Profit, we win $150 on the first one and $200 on the second, for a total of $350 (the second trade will travel 40 pips to reach the Take Profit level because we opened it at 1.1990).
Our Risk is smaller (stop loss on the first trade is 30 pips and on the second, 20 pips), but the Reward is bigger! If the trade goes another 10 pips against us and reaches 1.1980, we open another long trade with 0.50 (we will now have three long trades open). Now if the trade goes our way and the Take Profit is hit, we win $150 on the first, $200 on the second and $250 on the third, for a total of 600$, double what we could make if we traded one lot with 30 pips Stop Loss and 30 pips Take Profit. The beautiful thing is that if the trade closes at Stop Loss, we only lose $300: First trade loses $150: it is opened at 1.2000 and it closes at 1.1970 (30pips*$0.50/pip = $150) Second trade loses $100: it is opened at 1.1990 and closes at 1.1970 (20pips*$0.50/pip = $100) Third trade loses $50: it is open at 1.1980 and closes at 1.1970 (10pips*$0.50/pip = $50)
As we can see from the calculation above, our Risk is the same but our Reward DOUBLED!